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Chapter 11: Derivatives CHAPTER 11 DERIVATIVES by Vijay Singal, PhD, CFA LEARNING OUTCOMES After completing this chapter, you should be able to do the following: a Define a derivative contract; b Describe uses of derivative contracts; c Describe key terms of derivative contracts; d Describe forwards and futures; e Distinguish between forwards and futures; f Describe options and their uses; g Define swaps and their uses. Uses of Derivatives Contracts 345 INTRODUCTION 1 When you plan a vacation, you do not usually wait until you get to your planned des- tination to book a room. Booking a hotel room in advance provides assurance that a room will be available and locks in the price. Your action reduces uncertainty (risk) for you. It also reduces uncertainty for the hotel. Now imagine that you are a wheat farmer and want to reduce some of the risk of farming. You might presell some of your crop at a fixed price. In fact, contracts to reduce the uncertainty of agricultural products have been traced back to the 16th century. These contracts on agricultural products may be the oldest form of what are known as derivatives contracts or, sim- ply, derivatives. Derivatives are contracts that derive their value from the performance of an underly- ing asset, event, or outcome—hence their name. Since the development of derivatives contracts to help reduce risk for farmers, the uses and types of derivatives contracts and the size of the derivatives market have increased significantly. Derivatives are no longer just about reducing risk, but form part of the investment strategies of many fund managers. The size of the global derivatives market is now around $800 trillion. To put this figure in context, the combined value of every exchange-listed company in the United States is around $23 trillion.1 Given their sheer volume, derivatives are very important to financial markets and the work of investment professionals. USES OF DERIVATIVES CONTRACTS 2 Derivatives can be created on any asset, event, or outcome, which is called the under- lying. The underlying can be a real asset, such as wheat or gold, or a financial asset, such as the share of a company. The underlying can also be a broad market index, such as the S&P 500 Index or the FTSE 100 Index. The underlying can be an outcome, such as a day with temperatures under or over a specified temperature (also known as heating and cooling days), or an event, such as bankruptcy. Derivatives can be used to manage risks associated with the underlying, but they may also result in increased risk exposure for the other party to the contract. Let us continue the story of the wheat farmer. The farmer anticipates having at least 50,000 bushels of wheat available for sale in mid- September, six months from now. Wheat is currently trading in the market at $9.00 per bushel, which is the spot price. The farmer has no way of knowing what the market price of wheat will be in six months. The farmer finds a cereal producer that needs wheat and is willing to contract to buy 1 Information from “Centrally Cleared Derivatives: Clear and Present Danger”, Economist (4 April 2012). © 2014 CFA Institute. All rights reserved. 346 Chapter 11 ■ Derivatives 50,000 bushels of wheat at a price of $8.50 per bushel in six months. The contract provides a hedge for both the farmer and the cereal producer. A hedge is an action that reduces uncertainty or risk. Underlying But what if the farmer cannot find someone who actually needs the wheat? The farmer might still find a counterparty that is willing to enter into a contract to buy the wheat in the future at an agreed on price. This counterparty may anticipate being able to sell the wheat at a higher price in the market than the price agreed on with the farmer. This counterparty may be called a speculator. This counterparty is not hedging risk but is instead taking on risk in anticipation of earning a return. But there is no guarantee of a return. Even if the price in the market is lower than the price agreed on with the farmer, the counterparty has to buy the wheat at the agreed on price and then may have to sell it at a loss. Derivatives allow companies and investors to manage future risks related to raw material prices, product prices, interest rates, exchange rates, and even uncontrollable factors, such as weather. They also allow investors to gain exposure to underlying assets while committing much less capital and incurring lower transaction costs than if they had invested directly in the assets. 3 KEY TERMS OF DERIVATIVES CONTRACTS There are four main types of derivatives contracts: forward contracts (forwards), futures contracts (futures), option contracts (options), and swap contracts (swaps). Each of these will be discussed in the following sections. All derivatives contracts specify four key terms: the (1) underlying, (2) size and price, (3) expiration date, and (4) settlement. Key Terms of Derivatives Contracts 347 3.1 Underlying Derivatives are constructed based on an underlying, which is specified in the contract. Originally, all derivatives were based only on tangible assets, but now some contracts are based on outcomes. Examples of underlyings include the following: ■■ Agricultural products (such as wheat, rice, soybeans, cotton, butter, and milk) ■■ Livestock (such as hogs and cattle) ■■ Currencies ■■ Interest rates ■■ Individual shares and equity indices ■■ Bond indices ■■ Economic factors (such as the inflation rate) ■■ Natural resources (such as crude oil, natural gas, gold, silver, and timber) ■■ Weather- related outcomes (such as heating or cooling days) ■■ Other products (such as electricity or fertilisers) A derivative’s underlying must be clearly defined because quality can vary. For example, crude oil is classified by specific attributes, such as its American Petroleum Institute (API) gravity, specific gravity, and sulphur content; Brent crude oil, light sweet crude oil, and crude oil are different underlyings. Similarly, there is a difference between Black Sea Wheat, Soft Red Winter Wheat No. 1 and No.2, and KC Hard Red Winter Wheat No. 1 and No. 2. 3.2 Size and Price The contract must also specify size and price. The size is the amount of the underly- ing to be exchanged. The price is what the underlying will be purchased or sold for under the terms of the contract. The price specified in the contract may be called the exercise price or the strike price. Note that the price specified in the contract is not the current or spot price for the underlying but a price that is good for future delivery. 3.3 Expiration Date All derivatives have a finite life; each contract specifies a date on which the contract ends, called the expiration date. 3.4 Settlement Settlement describes how a contract is satisfied at expiration. Some contracts require settlement by physical delivery of the underlying and other contracts allow for or even require cash settlement. If physical delivery to settle is possible, the contract will 348 Chapter 11 ■ Derivatives specify delivery location(s). Contracts with underlying outcomes, such as heating or cooling days, cannot be settled through physical delivery and must be settled in cash. In practice, most derivatives contracts are settled in cash. 4 FORWARDS AND FUTURES Forwards and futures involve obligations in the future on the part of both parties to the contract. Forward and futures contracts are sometimes termed forward commit- ments or bilateral contracts because both parties have a commitment in the future. Bilateral contracts expose each party to the risk that the other party will not fulfil the contractual agreement. 4.1 Forwards A forward contract is an agreement between two parties in which one party agrees to buy from the seller an underlying at a later date for a price established at the start of the contract. The future date can be in one month, in one year, in five years, or at any other specified date. Investors primarily use forward contracts to lock in the price of an underlying and to gain certainty about future financial outcomes. Example 1 continues the story of the farmer and describes a forward contract between the farmer and a cereal producer. EXAMPLE 1. FORWARD CONTRACT BETWEEN FARMER AND CEREAL PRODUCER The contract between the farmer and cereal producer for 50,000 bushels of wheat in mid- September, six months from now, at $8.50 per bushel is a forward contract. The underlying is wheat, the size is 50,000 bushels, the exercise price is $8.50 per bushel, the expiration date is mid- September, and settlement will be with physical delivery. In September, the farmer will deliver the wheat to the cereal producer and receive $8.50 per bushel. Forwards and Futures 349 Underlying Maturity (six months) March September (contract signed) (contract ends) Exercise Price: Farmer: $8.50 per bushel Delivers 50,000 bushels Size: Cereal Producer: 50,000 bushels Pays $8.50 per bushel Settlement: Physical Delivery By entering into the forward contract, the farmer knows the wheat will sell and has eliminated uncertainty about how much money will be received for the wheat. The cereal producer knows that wheat will be available and has eliminated uncertainty about how much the wheat will cost. Forward contracts transact in the over- the-counter market—that is, the agreement is made directly between two parties, a buyer and a seller—although a dealer may help arrange the agreement.2 The risk that the other party to the contract will not fulfil its contractual obligations is called counterparty risk. To reduce counterparty risk, the parties to a forward contract evaluate the default risk of the other party before entering into a contract.
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